PORTFOLIO CONSTRUCTION

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INTRODUCTION TO EFFICIENT PORTFOLIO
MARKOWITZ PORTFOLIO THEORY

Bringing risk and return into the picture of investment management – Markowitz optimization

Modeling risk and return – CAPM and variations

Estimating risk and return – the Single-Index Model (SIM) and risk and expected return factor models

These provide the framework for both modern finance, which we have briefly discussed already, as well
as for quantitative investment management, which will be the subject of the next section of the course

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INTRODUCTION TO EFFICIENT PORTFOLIO
UNDERSTANDING BASICS

What do we mean by risk aversion and what evidence indicates that investors are generally risk averse

What are the basic assumptions behind the Markowitz portfolio theory

What is meant by risk and what are some of the alternative measures of risk used in investments?

How do you compute the expected rate of return for an individual risky asset or a portfolio of assets

How do you compute the standard deviation of rates of return for an individual risky asset

What is meant by the covariance between rates of return and how do you compute covariance

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INTRODUCTION TO EFFICIENT PORTFOLIO
BUILDING BLOCKS OF MPT

As an investor you want to maximize the returns for a given level of risk
 Or reduce the risk for given levels of returns

The relationship between the returns for the different assets in the portfolio is important

A good portfolio is not simply a collection of individually good investments

Given a choice between two assets with equal rates of return, most investors will select the asset with the
lower level of risk

Old adage is:“Don’t put all your eggs in one basket.”But, how many baskets should you use? And how what proportion
of your eggs should you put in each basket?

Harry Markowitz wrestled with these questions figured out a way to answer both of them Earned a Nobel Prize
in Economics (1990) for his efforts
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INTRODUCTION TO EFFICIENT PORTFOLIO
MPT OUTCOME

Quantifies risk

Derives the expected rate of return for a portfolio of assets and an expected risk measure

Shows that the variance of the rate of return is a meaningful measure of portfolio risk

Derives the formula for computing the variance of a portfolio, showing how to effectively diversify a
portfolio

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INTRODUCTION TO EFFICIENT PORTFOLIO
MPT ASSUMPTIONS

Investors consider each investment alternative as being presented by a probability distribution of

Investors minimize one-period expected utility, and their utility curves demonstrate diminishing marginal
utility of wealth
 investors like higher returns, but they are risk-averse in seeking those returns

Investors estimate the risk of the portfolio on the basis of the variability of expected returns
 out of all the possible measures, variance is the key measure of risk

Investors base decisions solely on expected return and risk

For a given risk level, investors prefer higher returns to lower returns. Similarly, for a given level of
expected returns, investors prefer less risk to more risk 6
INTRODUCTION TO EFFICIENT PORTFOLIO
MPT CALCULATIONS

Any asset of a portfolio may be described by two characteristics

The expected rate of return

The expected standard deviations of returns

The covariance between a pair of stocks, also drives the portfolio standard deviation
 Unlike portfolio expected return, portfolio standard deviation is not simply a weighted average of the standard
deviations for the individual stocks
 For a well-diversified portfolio, the main source of portfolio risk is covariance risk; the lower the covariance risk, the
lower the total portfolio risk

What could have been covariance/correlation across Assets in Covid breakout i.e. March
2020
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INTRODUCTION TO EFFICIENT PORTFOLIO
PARAMETERS EVALUATION

Unfortunately, no one knows the true values for the expected return and variance and covariance of
returns

These must be estimated from the available data

The most basic way to estimate these is the naïve or unconditional estimate uses the sample mean, sample
variance, and sample covariance from a time series sample of stock returns

Typical time series used is last 60 months’ (5 years’) worth of monthly returns

Why is it difficult to diversified portfolio with addition of Crypto, NFTs ?

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INTRODUCTION TO EFFICIENT PORTFOLIO
EXAMPLES

Optimal construction is interplay between Risk and Return

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INTRODUCTION TO EFFICIENT PORTFOLIO
EXAMPLES

Under Different Scenarios of weights and correlation

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INTRODUCTION TO EFFICIENT PORTFOLIO
EXAMPLES

Under Different Scenarios of weights and correlation

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INTRODUCTION TO EFFICIENT PORTFOLIO
CONCLUSION

An individual investor’s utility curve specifies the trade-offs he is willing to make between expected
return and risk

The slope of the efficient frontier curve decreases steadily as you move upward

These two interactions will determine the particular portfolio selected by an individual investor

The optimal portfolio has the highest utility for a given investor

It lies at the point of tangency between the efficient frontier and the utility curve with the highest
possible utility

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INTRODUCTION TO EFFICIENT PORTFOLIO
CONCLUSION

Results of portfolio allocation depend on accurate statistical inputs

Estimates of
 Expected returns ( n estimates)
 Standard deviation ( n estimates)
 Correlation coefficient ( [n(n-1)/2] estimates)
 Among entire set of assets with 100 assets, 4,950 correlation estimates
 With 500 assets, 124,750 correlation estimates
 Estimation risk refers to potential errors
 Typically only have between 60n and 260n observation data points from which to obtain estimates

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BENEFITS OF DIVERSIFICATION
Example

Portfolio of 2 stocks, 60% in A, 40% in B

What is portfolio Risk with below covariance

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